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US Dollar in for a Wild Ride as Stimulus Hopes Pumped Before ECB, Fed

US Dollar in for a Wild Ride as Stimulus Hopes Pumped Before ECB, Fed

John Kicklighter, Chief Strategist
US_Dollar_in_for_a_Wild_Ride_as_Stimulus_Hopes_Pumped_Before_ECB_Fed_body_Picture_5.png, US Dollar in for a Wild Ride as Stimulus Hopes Pumped Before ECB, Fed

Fundamental Forecast for US Dollar: Neutral

  • The US economy slows to a 1.5 percent clip, market baited into stimulus expectations
  • Speculation that ECB’s Draghi stepping up Euro crisis fight, feeds risk appetite and hurts the dollar
  • Is the US dollar’s recent reversal the sign for a lasting trend?

What started out as a fundamentally-weighted, risk aversion move last week (bullish for the safe haven dollar) turned into a hope-driven stimulus rebound for investor sentiment. This is a familiar theme for dollar traders and the markets in general. When underlying fundamentals start to set in, policy officials react to prevent volatility that could result from speculative deleveraging and thereby cause dislocation in credit and financing (in other words a financial crisis). It’s an unstoppable force against an immovable object between economic realty and policy officials’ commitment to prevent a meltdown (read via capital markets). This will prove a source of considerable volatility heading into next week as we have the Fed and ECB rate decisions (as well as US NFPs) on tap. Expectations will be running high, but disappointment can prove disastrous.

The top concern for the dollar heading into next week is the round of monetary policy meetings. As dollar traders have to be tapped into risk appetite trends, the speculative balance heading into the decisions will be as important as the outcomes themselves – at least for price action through the first half of the week. As we saw through the end of this past week, expectations are running high that there will be another round of support offered by world’s largest central banks (making them arguably the largest buyers in a market that is thin on participation). There is an inherent dilemma to dependency on central banks for keeping capital markets buoyant – as the fundamental backdrop remains unchanged or worsens, stimulus efforts need to growth with each round. Eventually, the realization that support will end and have to be withdrawn will catch up to the markets. The hope is that markets will be self-sustaining at that point to offset the exit.

First on deck is the Federal Reserve’s announcement on Wednesday. There has been considerable speculation paid to the scenario that the world’s largest central bank escalates its efforts. Considering the FOMC announced the extension of their Operation Twist program ($276 billion) at their last meeting and 2Q GDP was generally stable at 1.5 percent (annualized) according to Friday’s data, the domestic pressure for a move is relatively modest. A preemptive move is always a possibility, and the effort to stabilizing global crises before they become US issues (like the Euro Zone crisis) cannot be written off. Yet, many Fed officials have voiced reticence about expanding the program once again, and even the doves have begun to admit that further stimulus would likely have a diminished impact. Therefore, even if there is a next move, it could be judged for its limitations as much as its support. Of course, a hold could deflate short-term speculative hopes.

Though the Fed has been the more prolific and arguably effective stimulator, the market is likely more concerned about the ECB’s next moves. The market recognizes the Euro Zone financial troubles as the greatest overall risk to the global system. Not only does the slowdown in the world’s largest collective economy threaten a significant weight, but the funding issues pose a threat that could be just as prolific as the agency and mortgage-backed securities did back in 2008. Through the end of this past week, the S&P 500 and Dow were driven to multi-month highs while EURUSD managed to close back above 1.2300 on the back of expectations that ECB President Draghi was prepared to leverage the crisis fight by reviving bond purchases, rate cuts and/or another large-scale liquidity program (LTRO). There are serious reasons to doubt immediate implication (such as previous vows about their mandates and financing government debt, the need for a simultaneous approval for the ESM to buy bonds and the reality that these are still band aids rather than structural solutions).

If the Fed and ECB disappoint next week, it could spell serious trouble for the markets. Underlying fundamentals these past weeks have weakened and confidence in troubled assets has clearly ebbed. Should it become apparent that only moral hazard is keeping these markets buoyant, this past week’s pick up may have just added volatility to an inevitable collapse in speculative interests. We will have to see how the pieces fall Wednesday and Thursday, but the market will be comparing hopes to reality soon after the gatherings with July NFPs due on Friday. And, keeping open to all scenarios, the ‘fat-tail’ event would be a coordinated effort on large scale programs. – JK

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.